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Weighing Asset Allocation As The Fiscal Cliff Looms

With the presidential election now over, it's time for investors
to consider what the looming fiscal cliff could mean for asset
allocation in 2013. While no one can predict the future, I don't
expect next year to be characterized by a "normal" investing
environment that is well suited for a typical strategic allocation
strategy. Instead, 2013 offers two very distinct scenarios. First,
there is the possibility of a fiscal cliff-induced recession.
Second, there is the possibility of continuing gains in equities if
the cliff is avoided and the US economy continues on its recovery
path.

How should an investor approach asset allocation given the
uncertain outlook? I'd recommend taking into account the different
probabilities
of 2013 experiencing a cliff-induced recession.

To do that, let's construct a portfolio that is a mix of stocks
and bonds to be held over the next year. Then, let's look at the
range of possible return outcomes if next year turns out to be a
"typical year." I have taken monthly return data (in excess of the
30-day government yield) for the U.S. stock market and the U.S.
bond market since 1926[1], and I've computed the 12-month returns
of simple bond/stock portfolios for all possible 12-month periods
since 1926. The results are summarized in the three lines in this
chart: the typical return, the potential upside return (defined as
75
th
percentile of return outcomes), and the potential downside return
(defined as the 25
th
percentile of return outcomes):

(click to enlarge)
The horizontal axis shows the percentage allocated to bonds and the
vertical axis shows the typical 1-year returns of these portfolios
over the last 85 years. The chart confirms what could be considered
standard intuition: Taking a higher allocation in equities produces
higher returns, as shown by the median return line. But it also
produces a wider range of returns, as indicated by the 25th and
75th percentile lines, which is reflective of the increased risk
that a higher allocation to equities produces.

Now, what would happen if the United States went over the cliff
in 2013, creating negative economic growth through part of the
year? To answer that, let's look at what happens to the returns of
a typical portfolio that experiences an economic contraction in the
year after the simple bond/stock portfolio has been constructed[2].
Data from the1926-2012 period shows that if a portfolio is
constructed at the end of a month that is not already classified as
an economic contraction then the probability that there will be at
least one quarter of negative growth over the following 12 months
is about 15%. In other words, investors who think that the
probability of a fiscal cliff-induced economic contraction in 2013
is the same as the "normal" 15% probability of contraction can use
the chart above as a guide for simple allocation.

What about investors who think the probability of a
cliff-induced recession is higher than normal? The chart below
shows what happens if the probability of a cliff-induced economic
contraction is set at 50% instead of 15%[3], as Russ has
argued recently
.

(click to enlarge)
The chart suggests that even for aggressive investors there is
little reason to have a large allocation to equities if you believe
there is a higher-than-normal chance of a recession. The chart
shows that holding more equities would not be expected to produce
returns that are materially better than a conservative allocation.
In addition, the size of the potential downside also increases
across the board - in other words, an investor is not likely to be
rewarded for taking on additional risk.

The upshot of this analysis? Investors do
not
need to have high conviction that cliff-induced recession will take
place next year to consider some reallocation in their portfolios.
History suggests that an even 50/50 chance of recession in the next
12 months (compared to the 15% normal chance) can have a material
impact on the typical 1-year returns associated with a simple
bond/equities allocation. As we have
argued in the past
, investors concerned about heightened volatility on the back of
longer-term macroeconomic concerns - including a cliff-induced
recession - should consider some reallocation toward
dividend-paying equities
as well as managed volatility portfolios.

[1] Stock return data is from Fama-French, reflective of the
return of the total U.S. stock market as commonly used in
academic research. The 30-day government rate (or "risk free"
rate) is also from Fama-French. Return data for bonds is from
the IA SSBI database, computed as a combination of corporate
bond total returns (weighted at 33%) and intermediate
government bond returns (weighted at 64%).

[2] I used the standard NBER classification of U.S. economic
cycles to classify every month in the 1926-2012 period as
either in contraction or expansion.

[3] This chart is constructed in the same way as the first
chart, except that periods of economic contraction (i.e. 1 year
periods with at least 3 months classified as contraction) are
weighted so as to account for a 50/50 chance of occurrence.

Disclaimer:
This material represents an assessment of the market
environment at a specific time and is not intended to be a
forecast of future events or a guarantee of future results.
This information should not be relied upon by the reader as
research or investment advice regarding the funds or any
security in particular. Past performance does not guarantee
future results.

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